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Moving Averages Explained
Moving Averages
Explained
Beginner
1mo ago
5m
Technical analysis (TA) is nothing new in the world of trading and
investing. From traditional portfolios to cryptocurrencies
like Bitcoin and Ethereum, the use of TA indicators has a simple
goal: use existing data to make more informed decisions that will
likely lead to desired outcomes. As markets grow increasingly more
complicated, the last decades have produced hundreds of different
types of TA indicators, but few have seen the popularity and
consistent usage of moving averages (MA).
Although there are different variations of moving averages, their
underlying purpose is to drive clarity in trading charts. This is done
by smoothing out the graphs to create an easily decipherable trend
indicator. Because these moving averages rely on past data, they
are considered to be lagging or trend following indicators.
Regardless, they still have great power to cut through the noise and
help determine where a market may be heading.
Different types of moving averages
There are various different types of moving averages that can be
utilized by traders not only in day trading and swing trading but also
in longer-term setups. Despite the various types, the MAs are most
commonly broken down into two separate categories: simple
moving averages (SMA) and exponential moving averages (EMA).
Depending on the market and desired outcome, traders can choose
which indicator will most likely benefit their setup.
The simple moving average
The SMA takes data from a set period of time and produces the
average price of that security for the data set. The difference
between an SMA and a basic average of the past prices is that with
SMA, as soon as a new data set is entered, the oldest data set is
disregarded. So if the simple moving average calculates the mean
based on 10 days worth of data, the entire data set is constantly
being updated to only include the last 10 days.
It's important to note that all data inputs in an SMA are weighted
equally, regardless of how recently they were inputted. Traders who
believe that there's more relevance to the newest data available
often state that the equal weighting of the SMA is detrimental to the
technical analysis. The exponential moving average (EMA) was
created to address this problem.
The exponential moving average
EMAs are similar to SMAs in that they provide technical analysis
based on past price fluctuations. However, the equation is a bit
more complicated because an EMA assigns more weight and value
to the most recent price inputs. Although both averages have value
and are widely used, the EMA is more responsive to sudden price
fluctuations and reversals.
Because EMAs are more likely to project price reversals faster than
SMAs, they are often especially favored by traders who are
engaged in short-term trading. It is important for a trader
or investor to choose the type of moving average according to his
personal strategies and goals, adjusting the settings accordingly.
How to use moving averages
Because MAs utilize past prices instead of current prices, they have
a certain period of lag. The more expansive the data set is, the
larger the lag will be. For example, a moving average that analyzes
the past 100 days will respond more slowly to new information than
an MA that only considers the past 10 days. That's simply because
a new entry into a larger dataset will have a smaller effect on the
overall numbers.
Both can be advantageous depending on the trading setup. Larger
data sets benefit long-term investors because they are less likely to
be greatly altered due to one or two large fluctuations. Short-
term traders often favor a smaller data set that
allows for more reactionary trading.
Within traditional markets, MAs of 50, 100 and 200 days are the
most commonly used. The 50-day and the 200-day moving
averages are closely watched by stock traders and any breaks
above or below these lines are usually regarded as important
trading signals, especially when they are followed by crossovers.
The same applies to cryptocurrency trading but due
to its
24/7 volatile markets, the MA settings and
trading strategy may vary according to the
trader profile.
Crossover signals
Naturally, a rising MA suggests an upward trend and a falling MA
indicates a downtrend. However, a moving average alone is not a
really reliable and strong indicator. Therefore, MAs are constantly
used in combination to spot bullish and bearish crossover signals.
A crossover signal is created when two
different MAs crossover in a chart. A
bullish crossover (also known as a golden
cross) happens when the short-term MA
crosses above a long-term one,
suggesting the start of an upward trend. In
contrast, a bearish crossover (or death
cross) happens when a short-term MA
crosses below a long-term moving
average, which indicates the beginning of
a downtrend.
Other factors worth considering
The examples so far have all been in terms of days, but that's not a
necessary requirement when analyzing MAs. Those engaged in day
trading may be much more interested in how an asset has
performed over the past two or three hours, not two or three
months. Different time frames can all be plugged into the equations
used to calculate moving averages, and as long as those time
frames are consistent with the trading strategy, the data can be
useful.
One major downside of MAs is their lag time.
Since MAs are lagging indicators that consider
previous price action, the signals are often too
late. For instance, a bullish crossover may
suggest a buy, but it may only happen after a
significant rise in price.
This means that even if the uptrend continues, potential profit may
have been lost in that period between the rise in price and the
crossover signal. Or even worse, a false golden cross signal may
lead a trader to buy the local top just before a price drop. These
fake buy signals are usually referred to as a bull trap.
Closing thoughts
Moving Averages are powerful TA indicators and one of the most
widely used. The ability to analyze market trends in a data-driven
manner provides great insight into how a market is performing.
Keep in mind, however, that MAs and crossover signals should not
be used alone and it is always safer to combine different TA
indicators in order to avoid fake signals.
